Monday, October 19, 2015

Knowledge@Wharton: "Why Wall Street Traders Keep Making a Fortune"

From K@W, UPenn:

Wall Street traders are a breed apart from other financial services professionals when it comes to compensation, which can run up to several million dollars a year. And even among traders, some can make substantially more than others even if, on the surface, they all share the same skills.

In the research paper, “Compensating Financial Experts,” Wharton finance professor Vincent Glode and Richard Lowery of the University of Texas at Austin discovered that traders are paid a “defense premium” by their employers for not working for competitors that could use their trading skills against them. Trading is a zero-sum game in which each party in either side of a transaction tries to gain the upper hand from the other.

And the more concentrated the market — for example, the number of employers in the interest-rate options arena is far fewer than those in the foreign-exchange options market — the higher the pay for traders. This finding defies conventional wisdom that says fewer employers mean there would be less demand for these jobs and hence depress wages.

Other financial services professionals such as bankers are paid less because they do not get the “defense premium.” So it matters less where the banker works; opposing firms do not suffer as much by not hiring this person. That’s because bankers, for example, identify new investment opportunities that can benefit the whole financial services sector since the investment pie gets bigger and many financial firms collect higher trading profits as a result.

In this interview with Knowledge@Wharton, Glode explains why average compensation in the financial sector has increased in recent decades despite the flood of workers entering it and sheds light on the reversal in the types of financial jobs that have been considered the most lucrative over the years.An edited transcript of the conversation appears below.

Surplus or Zero-sum?In my paper with Richard Lowery from the University of Texas at Austin, we tried to understand how specific tasks that workers in finance perform will affect their compensation. We think this is an important topic, because the financial sector is a big part of the economy. In the U.S., the financial sector represents 10% of U.S. GDP. Also, a lot of the money that is flowing through the financial sector ends up being used to compensate workers. Typically, a Wall Street firm will use 50% of its revenues to pay its workers.

The defense premium is “how much you are willing to pay for a worker to make sure he or she does not work for one of your counterparties, and use his competitive advantage against you.”

There’s a lot of money that is flowing from the U.S. economy to financial workers and we try to understand how that works. So what we do in the paper is, we propose a labor market model where financial firms compete for the services of a limited supply of skilled workers. And these workers can be allocated, or they can be hired, to become traders who speculate with other firms about the value of an asset, or they can be hired to create a surplus by finding profitable investment opportunities.

For the first task … they participate in a zero sum game. They help the firm extract surplus away from rival firms. On the other hand, if these workers are hired to find profitable investment opportunities, like finding the next Tesla or finding the next Facebook, they create a surplus for the whole sector....MORE